The Delta and Northwest Merger
April 22nd, 2008I have been asked my opinion of the Delta/Northwest deal by several students and friends. Quite frankly, I do not know enough about either firm to comment in great detail. But that has never stopped me before. So here goes…
Provided that regulators and the employee unions at both firms allow this deal to go through, the success of this merger hinges on two specific factors:
- The ability to wield increasing market power – restricting supply and eliminating routes in an effort to gain more pricing power, raise fares, and generate additional profits.
- The ability to generate cost saving synergies – in fleets, gates, reservation systems, maintenance, management, etc. – thereby raising profits.
With respect to the former, there will no doubt be opportunities for the combined firms to exercise some pricing power. Moreover, with gasoline prices at an all time high, this rationale for their combination makes economic sense.
With respect to the latter, both of these firms are struggling. Each has recently emerged from bankruptcy, and both have cost structures that are too high relative to the competition. I have never been a big proponent of the idea that bringing two bad firms together suddenly yields one good firm. This deal is no exception. I am therefore skeptical about their ability to generate meaningful synergies by combining forces.
All told, although I believe that the potential for pricing power is there, the additional pricing power will not address the fundamental problems that each firm faces. Moreover, the synergies will not make up the difference. For this reason, my off-the-cuff priors would be to expect the combined firm to fail, …as would either firm left to its own devices.
The real question though is whether Delta and Northwest have more of a fighting chance together or separately. Unfortunately, my answer is that in this case, it likely doesn’t matters much either way.
The most recent issue of the Economist has a nice analysis of the deal (see Trouble in the Air). They write:
Darkening economic clouds, oil at $114 a barrel, cut-throat competition and disappearing credit lines are confronting airlines with their biggest crisis since the dark days after September 11th 2001. It is a measure of the panic sweeping the industry that Delta and Northwest said this week they would push ahead with their $3.6 billion merger to create the world’s biggest airline by traffic…[T]he two airlines have decided to take the risk of a potentially long-drawn-out and fractious integration of their operations because they calculate that a merger is their best chance of survival as the industry’s woes deepen.
Delta and Northwest…having only recently emerged from Chapter 11 bankruptcy protection themselves…know that time is not on their side. After a strong recovery by America’s airlines in the past few years, profitability has fallen fast this year. And balance sheets are still weak, even at the big network carriers.
Delta has 117 McDonnell Douglas MD-88s with an average age of 18 years; Northwest soldiers on with more than 90 DC-9s with an average age nudging 40 years. These planes are up to 40% thirstier than their more modern counterparts, a crippling burden given the price of fuel. They are also more difficult to maintain—as last week’s grounding of American Airlines’ similarly elderly MD-80s highlighted.
Delta and Northwest have little scope to cut front-line staff or replace their ageing fleets any time soon—production lines at Boeing and Airbus are fully booked until 2012. But they think they can secure cost reductions of about $1 billion a year by centralising their back-office operations and cutting management jobs. They also hope to boost revenue by combining route networks and strengthening their appeal to lucrative corporate customers.
So there you have it. My opinion on the deal given what limited information I have on each firm.
